Many securities brokers
work for commissions. This means that they charge investors a fee whenever
executing a trade on their behalf. This method of compensation has, in the
past, enticed some nefarious brokers to increase their compensation by making
more trades on a customer’s behalf than is in the customer’s best interest.
What
is Excessive Trading?
Excessive
trading, also known as churning, occurs when a securities broker executes
trades in a customer’s account at an unsuitable frequency in an effort to
increase their own commissions. Make no mistake, excessive trading is illegal.
Unfortunately, in all but the most egregious circumstances, you may need to
consult a professional to determine whether you are a victim of excessive
trading. There is no “one size fits all” test to determine whether a broker is
churning a customer’s account. Instead, courts and regulators balance several
factors to determine whether a broker’s trading would be deemed excessive. It
is determined by the volume at which trades are being executed, the type of
security being traded, the investor’s stated investment objectives and the
investor’s risk tolerance (including their age, net worth, and investment
experience). For instance, the same number of trades may be suitable for an
investor with more speculative objectives but unsuitable for an investor with
more conservative objectives. Moreover, one type of product traded a certain
number of times may be suitable; whereas, a different type of product—not meant
for that volume of trading—traded just as many times may be unsuitable.
The Harms of Excessive Trading
Excessive trading can cause significant and irreparable harm to investors beyond simply loss of principal. It will almost always prevent the desired growth due both to excessive fees that accompany it and the excessive switching of investment products that will only yield growth if they are held onto for certain periods of time. Even if an investor’s principal investment remains intact after a ten year period, the fact that an account achieved no, or minimal, growth over that period—when a properly traded account would have seen the growth the investor desired—can cause damage to an investor’s financial health which cannot be undone.
The Evolution of Excessive Trading
Excessive
trading primarily occurs when securities brokers engage in unnecessarily
frequent switching of equities sold on public securities exchanges. When this
occurs, the broker “earns” a commission for each trade. Over time, these
charges compound and cause substantial harm. In recent years, more and more
securities brokers are starting to engage in excessive trading of more long
term investment products not sold on public exchanges such as mutual funds,
unit investment trusts, private equity funds, closed-end funds, and, most
notably, variable annuities. Long-term product switching, especially when it
involves variable annuities, does not need to occur at the same volume as
equity switching in order to be deemed excessive. For example, annuities are specifically designed to be held onto
long term and are often marketed to elderly vulnerable investors with very low
risk tolerance. Investors placed in products such as variable annuities may be
charged inordinately high[1] fees when they are both
placed in and exit the product. That means that the fees investors incur as a
result of excessive trading will rack up even more when the trading involves
individually tailored private investment products like annuities.
The Indicators of Excessive Trading
Regulatory agencies such as FINRA have two main tools to
identify excessive trading. One is by looking at the Turn-Over Rate. This is
the number of times the securities in the account turn into new securities. The
second is called the Cost-Equity Ratio. This is the amount the account would
need to appreciate in order for the customer to simply cover the fees they are
being charged. A turn-over rate of 6 and a cost-equity ratio of 20 percent are
the prime indicators that excessive trading is most likely occurring. However,
as noted above, these are just two indicators of many. Excessive trading still
may exist where these indicators are not met.
Who Can Stop Excessive Trading?
More
so than both FINRA and the customers themselves, it is actually the
broker-dealer who is in the best position to both spot and put a stop to
excessive trading. Many securities firms have alert systems in place where they
will be automatically be notified if an investor’s turn-over rate reaches 6 and
their cost-equity ratio reaches 20 percent; however, case-law dictates that
these two numbers are not necessary
to make someone liable for excessive trading. Many brokers engaging in this
practice know how to effectively skirt these alerts and avoid raising red flags
by engaging in trading that falls just
shy of reaching the numbers necessary to trigger the alerts. For this reason,
FINRA has called on all broker-dealers to be more vigilant in broker
supervision beyond merely “checking in on things” once an alert has gone off.
Unfortunately, it is incredibly difficult for investors
to recognize when excessive trading is actually occurring. The investor is not
trained in this industry and may only receive quarterly or annual statements
from their broker. In some of the most egregious violations, brokers will skirt
supervision mechanisms by fraudulently changing an investor’s preferences to
allow for more frequent and speculative trading, essentially banking on
investors not noticing the change in preferences on their account statements.
The best thing that investors can do is make sure that
their investment objectives and risk tolerance are listed correctly on account
statements, actively communicate with their broker, and take thorough notes of
their conversations. If investors do have any suspicions, they should never be afraid to call the
broker-dealer and speak to a supervising manager. Legitimate brokers are not
offended by this action and it will have no affect on your working
relationship.
Here at Cosgrove Law Group, LLC, we have substantial
experience dealing with fraud related to brokers and financial professionals. If
you suspect that you are a victim of excessive trading, contact the experienced
attorneys at Cosgrove Law Group, LLC.
[1] It
is not uncommon to see an investor charged 25 percent of their principal
investment if they exit an annuity early.
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